Investment insights

What’s the risk of not understanding risk?

April 2018

By MLC

For most investors, a conversation with a partner or friend about lifestyle goals helps identify what risk really means to them. It may be unknowingly formed over a cup of tea at the kitchen table when discussing saving enough to put the kids through school, or for a deposit on that first home. This discussion about risk is very real and easy to understand because it is relevant and the consequences are clear. You can close your eyes and easily imagine how it will affect your life.

However as investors approach financial markets, the original definition of risk quickly morphs into obscure terms like tracking error, sharpe ratio, and ex-ante volatility. Risk is re-defined to serve the investment strategies on offer rather than help the investor. But how does the investor make sense of this information when evaluating an investment against their definition of real life risk? Even under the guidance of a financial adviser, the change in risk dialect from that which started over a cuppa to the eventual investment solution renders it near impossible to translate this new description of risk back into anything meaningful.

The problem of understanding true investor risk has partly been solved by the emergence of ‘outcome-oriented solutions’ that seek to limit an investor’s exposure to declining asset prices. These funds seek a particular return above inflation over a number of years, but they do not seek higher returns if the risk of loss of capital is too high. This is a clear proposition for investors. The return outcome, which must at least preserve capital, is all that matters - there are no market benchmarks to hide behind. Such strategies require significant asset allocation flexibility. They cannot rely on the generosity of share markets and must be prepared for any market dislocation that might occur. The emphasis on not losing money provides a relevant risk expectation against what really matters to investors hoping to preserve capital and create wealth, and can be tied back to the initial risk conversation had over a cup of tea. The uncomfortable trade-off for investors is allowing the investment manager greater degrees of freedom to avoid the unattractive risks that markets inevitably bundle up with the attractive ones.

To use a motoring analogy, investors may choose to not bother themselves with the intricacies of all moving parts of an engine, however they should know their destination along with how fast their vehicle is willing to go. They would like to get to the destination as fast as possible, but also to ensure they arrive safely. Insight into these things helps understand the likelihood of an accident or being late and whether to get into the car at all. The very same considerations should be applied to any investment strategy and checked regularly.

Keeping all investor conversations about risk relevant and real is crucial for the wealth industry. Every discussion should somehow tie back to the approach (i.e the risks worth taking) and the progress (i.e returns earned) on the journey towards a specific wealth goal.

Important information

This publication is provided by MLC Investments Limited (ABN 30 002 641 661, AFSL 230705) (“MLC”), a member of the group of companies comprised National Australia Bank Limited (ABN 12 004 044 937, AFSL 230686), its related companies, associated entities and any officer, employee, agent, adviser or contractor therefore (“NAB Group”). An investment with MLC does not represent a deposit or liability of, and is not guaranteed by, NAB or any other member of the NAB Group.This information may constitute general advice. It has been prepared without taking account of your objectives, financial situation or needs and because of that you should, before acting on the advice, consider the appropriateness of the advice having regard to your personal objectives, financial situation and needs.

Opinions constitute the judgement of MLC at the time of issue and are subject to change. MLC believes that the information contained in this article is correct and that any estimates, opinions, conclusions or recommendations are reasonably held or made at the time of compilation. However, neither MLC nor any other member of the NAB Group, nor their employees or directors give any warranty as to their accuracy or reliability (which may change without notice) or other information contained in this article. This information is directed to and prepared for Australian residents only.